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Chapter 21 Option Valuation
Multiple Choice
Questions
1.
Before expiration, the
time value of an in the money call option is
always
A)
equal to zero.
B)
positive.
C)
negative.
D)
equal to the stock price minus the
exercise price.
E)
none of the above.
Answer: B
Difficulty: Easy
Rationale: The difference
between the actual option price and the intrinsic
value is
called the time value of the
option.
2.
Before expiration, the
time value of an in the money put option is always
A)
equal to zero.
B)
negative.
C)
positive.
D)
equal to the stock price minus the
exercise price.
E)
none of the above.
Answer: C
Difficulty: Easy
Rationale: The difference
between the actual option price and the intrinsic
value is
called the time value of the
option.
3.
Before expiration, the
time value of an at the money call option is
always
A)
positive.
B)
equal to zero.
C)
negative.
D)
equal to the stock price
minus the exercise price.
E)
none of the above.
Answer: A
Difficulty: Easy
Rationale: The difference
between the actual option price and the intrinsic
value is
called the time value of the
option.
527
Chapter 21 Option Valuation
4.
Before
expiration, the time value of an at the money put
option is always
A)
equal to zero.
B)
equal to the stock price
minus the exercise price.
C)
negative.
D)
positive.
E)
none of the above.
Answer: D Difficulty:
Easy
Rationale: The difference between the
actual option price and the intrinsic value is
called the time value of the
option.
5.
A call
option has an intrinsic value of zero if the
option is
A)
at
the money.
B)
out of the money.
C)
in the money.
D)
A and C.
E)
A and B.
Answer: E Difficulty: Easy
Rationale:
Intrinsic value can never be negative; thus it is
set equal to zero for out of the
money
and at the money options.
6.
A put option has an intrinsic value of
zero if the option is
A)
at the money.
B)
out of the money.
C)
in the money.
D)
A and C.
E)
A and B.
Answer: E Difficulty: Easy
Rationale:
Intrinsic value can never be negative; thus it is
set equal to zero for out of the
money
and at the money options.
7.
Prior to expiration
A)
the intrinsic value of a
call option is greater than its actual value.
B)
the intrinsic
value of a call option is always positive.
C)
the actual
value of call option is greater than the intrinsic
value.
D)
the
intrinsic value of a call option is always greater
than its time value.
E)
none of the above.
Answer: C Difficulty: Moderate
Rationale:
Prior to expiration, any option will be selling
for a positive price, thus the
actual
value is greater than the intrinsic
value.
528
Chapter 21 Option Valuation
8.
Prior to expiration
A)
the intrinsic value of a
put option is greater than its actual value.
B)
the intrinsic
value of a put option is always positive.
C)
the actual
value of put option is greater than the intrinsic
value.
D)
the
intrinsic value of a put option is always greater
than its time value.
E)
none of the above.
Answer: C Difficulty: Moderate
Rationale:
Prior to expiration, any option will be selling
for a positive price, thus the
actual
value is greater than the intrinsic
value.
9.
If the
stock price increases, the price of a put option
on that stock __________ and that
of a
call option __________.
A)
decreases, increases
B)
decreases, decreases
C)
increases,
decreases
D)
increases, increases
E)
does not change, does not
change
Answer: A
Difficulty: Moderate
Rationale: As stock prices increases,
call options become more valuable (the owner can
buy the stock at a bargain price). As
stock prices increase, put options become less
valuable (the owner can sell the stock
at a price less than market price).
10.
If the stock price decreases, the price
of a put option on that stock __________ and that
of a call option __________.
A)
decreases, increases
B)
decreases,
decreases
C)
increases, decreases
D)
increases,
increases
E)
does not change, does not change
Answer: C
Difficulty: Moderate
Rationale: As stock prices
decreases, call options become less valuable (the
owner can
buy the stock at a bargain
price). As stock prices decreases, put options
become more
valuable (the owner can
sell the stock at a price less than market
price).
529
Chapter 21 Option Valuation
11.
Other things equal, the price of a
stock call option is positively correlated with
the
following factors
except
A)
the stock price.
B)
the time to
expiration.
C)
the stock volatility.
D)
the exercise
price.
E)
none of the above.
Answer: D Difficulty:
Moderate
Rationale: The exercise price is
negatively correlated with the call option
price.
12.
Other things equal, the
price of a stock put option is positively
correlated with the
following factors
except
A)
the stock price.
B)
the time to expiration.
C)
the stock
volatility.
D)
the exercise price.
E)
none of the
above.
Answer:
A Difficulty: Moderate
Rationale: The exercise
price is negatively correlated with the stock
price.
13.
The price of a stock put
option is __________ correlated with the stock
price and
__________ correlated with
the striking price.
A)
positively, positively
B)
negatively, positively
C)
negatively,
negatively
D)
positively, negatively
E)
not, not
Answer: B
Difficulty: Moderate
Rationale: The lower the
stock price, the more valuable the call option.
The higher the
striking price, the more
valuable the put option.
530
Chapter 21 Option Valuation
14.
The price of a stock call option is
__________ correlated with the stock price and
__________ correlated with the striking
price.
A)
positively, positively
B)
negatively,
positively
C)
negatively, negatively
D)
positively,
negatively
E)
not, not
Answer: D Difficulty: Moderate
Rationale: The lower the stock price,
the more valuable the call option. The higher the
striking price, the more valuable the
put option.
15.
All the inputs in the
Black-Scholes Option Pricing Model are directly
observable
except
A)
the price of
the underlying security.
B)
the risk free rate of
interest.
C)
the time to expiration.
D)
the variance
of returns of the underlying asset return.
E)
none of the above.
Answer: D Difficulty:
Moderate
Rationale: The variance of the returns
of the underlying asset is not directly
observable,
but must be estimated from
historical data, from scenario analysis, or from
the prices of
other options.
16.
Delta
is defined as
A)
the change in the value of an option
for a dollar change in the price of the underlying
asset.
B)
the change in the value
of the underlying asset for a dollar change in the
call price.
C)
the percentage change in the value of
an option for a one percent change in the value
of the underlying asset.
D)
the change in
the volatility of the underlying stock price.
E)
none of the above.
Answer: A Difficulty:
Moderate
Rationale: An option's hedge ratio
(delta) is the change in the price of an option
for $$1
increase in the stock
price.
531
Chapter 21 Option Valuation
17.
A hedge ratio of 0.70 implies that a
hedged portfolio should consist of
A)
long 0.70
calls for each short stock.
B)
short 0.70
calls for each long stock.
C)
long 0.70 shares for each
short call.
D)
long 0.70 shares for each long call.
E)
none of the above.
Answer: C Difficulty:
Moderate
Rationale: The hedge ratio is the slope
of the option value as a function of the stock
value. A slope of 0.70 means that as
the stock increases in value by $$1, the option
increases by approximately $$0.70.
Thus, for every call written, 0.70 shares of stock
would be needed to hedge the investor's
portfolio.
18.
A hedge ratio for a call
option is ________ and a hedge ratio for a put
option is ______.
A)
negative, positive
B)
negative, negative
C)
positive,
negative
D)
positive, positive
E)
zero, zero
Answer: C
Difficulty: Moderate
Rationale: Call option
hedge ratios must be positive and less than 1.0,
and put option
ratios must be negative,
with a smaller absolute value than 1.0.
19.
A hedge ratio for a call is always
A)
equal to one.
B)
greater than one.
C)
between zero and one
D)
between minus
one and zero.
E)
of no restricted value
Answer: C
Difficulty: Moderate
Rationale: See rationale
for test bank question 21.18.
532
Chapter 21 Option
Valuation
20.
A hedge ratio for a put
is always
A)
equal to one.
B)
greater than one.
C)
between zero and one
D)
between minus
one and zero.
E)
of no restricted value
Answer: D
Difficulty: Moderate
Rationale: See rationale
for test bank question 21.18.
21.
The dollar change in the value of a
stock call option is always
A)
lower than
the dollar change in the value of the stock.
B)
higher than the dollar change in the
value of the stock.
C)
negatively correlated
with the change in the value of the stock.
D)
B
and C.
E)
A and C.
Answer: A Difficulty: Moderate
Rationale: The slope of the call option
valuation function is less than one.
22.
The percentage change in the stock call
option price divided by the percentage change in
the stock price is called
A)
the
elasticity of the option.
B)
the delta of the option.
C)
the theta of the option.
D)
the gamma of
the option.
E)
none of the above.
Answer: A Difficulty:
Moderate
Rationale: Option price elasticity
measures the percent change in the option price as
a
function of the percent change in the
stock price.
23.
The elasticity of a
stock call option is always
A)
greater than
one.
B)
smaller than one.
C)
negative.
D)
infinite.
E)
none of the above.
Answer: A
Difficulty: Moderate
Rationale: Option prices
are much more volatile than stock prices, as
option premiums
are much lower than
stock prices.
533
Chapter 21 Option Valuation
24.
The elasticity of a stock put option is
always
A)
positive.
B)
smaller than one.
C)
negative
D)
infinite
E)
none of the
above.
Answer:
C Difficulty: Moderate
Rationale: As put options
become more valuable as stock prices decline, the
elasticity of
a put option must be
negative.
25.
Portfolio A consists of
150 shares of stock and 300 calls on that stock.
Portfolio B
consists of 575 shares of
stock. The call delta is 0.7. Which portfolio
has a higher dollar
exposure to a
change in stock price?
A)
Portfolio B
B)
Portfolio A
C)
The two portfolios have the same
exposure
D)
A if the stock price increases and B if
it decreases.
E)
B if the stock price
decreases and A if it increases.
Answer: A Difficulty:
Difficult
Rationale: 300 calls (0.7) = 210 shares
+ 150 shares = 360 shares; 575 shares = 575
shares.
26.
Portfolio A
consists of 500 shares of stock and 500 calls on
that stock. Portfolio B
consists of
800 shares of stock. The call delta is 0.6.
Which portfolio has a higher dollar
exposure to a change in stock price?
A)
Portfolio B
B)
Portfolio A
C)
The two
portfolios have the same exposure
D)
A if the
stock price increases and B if it decreases.
E)
B
if the stock price decreases and A if it
increases.
Answer: C Difficulty: Difficult
Rationale: 500 calls (0.6) = 300 shares
+ 500 shares = 800 shares; 800 shares = 800
shares.
534
Chapter 21 Option Valuation
27.
Portfolio A consists of 400 shares of
stock and 400 calls on that stock. Portfolio B
consists of 500 shares of stock. The
call delta is 0.5. Which portfolio has a higher
dollar
exposure to a change in stock
price?
A)
Portfolio B
B)
Portfolio A
C)
The two
portfolios have the same exposure
D)
A if the
stock price increases and B if it decreases.
E)
B
if the stock price decreases and A if it
increases.
Answer: B Difficulty: Difficult
Rationale: 400 calls (0.5) = 200 shares
+ 400 shares = 600 shares; 500 shares = 500
shares.
28.
Portfolio A
consists of 600 shares of stock and 300 calls on
that stock. Portfolio B
consists of
685 shares of stock. The call delta is 0.3.
Which portfolio has a higher dollar
exposure to a change in stock price?
A)
Portfolio B
B)
Portfolio A
C)
The two
portfolios have the same exposure
D)
A if the
stock price increases and B if it decreases.
E)
B
if the stock price decreases and A if it
increases.
Answer: B Difficulty: Difficult
Rationale: 300 calls (0.3) = 90 shares
+ 600 shares = 690 shares; 685 shares = 685
shares.
29.
A portfolio
consists of 100 shares of stock and 1500 calls on
that stock. If the hedge
ratio for the
call is 0.7, what would be the dollar change in
the value of the portfolio in
response
to a one dollar decline in the stock price?
A)
+$$700
B)
+$$500
C)
-$$1,150
D)
-$$520
E)
none of the above
Answer: C
Difficulty: Difficult
Rationale: -$$100 +
[-$$1,500(0.7)] = -$$1,150.
535
Chapter 21 Option
Valuation
30.
A portfolio consists of
800 shares of stock and 100 calls on that stock.
If the hedge ratio
for the call is 0.5.
What would be the dollar change in the value of
the portfolio in
response to a one
dollar decline in the stock price?
A)
+$$700
B)
-$$850
C)
-$$580
D)
-$$520
E)
none of the above
Answer: B Difficulty:
Difficult
Rationale: -$$800 + [-$$100(0.5)] =
-$$850.
31.
A portfolio consists of
225 shares of stock and 300 calls on that stock.
If the hedge ratio
for the call is 0.4,
what would be the dollar change in the value of
the portfolio in
response to a one
dollar decline in the stock price?
A)
-$$345
B)
+$$500
C)
-$$580
D)
-$$520
E)
none of the above
Answer: A Difficulty:
Difficult
Rationale: -$$225 + [-$$300(0.4)] =
-$$345.
32.
A portfolio consists of
400 shares of stock and 200 calls on that stock.
If the hedge ratio
for the call is 0.6,
what would be the dollar change in the value of
the portfolio in
response to a one
dollar decline in the stock price?
A)
+$$700
B)
+$$500
C)
-$$580
D)
-$$520
E)
none of the above
Answer: D Difficulty:
Difficult
Rationale: -$$400 + [-$$200(0.6)] =
-$$520.
536
Chapter 21 Option Valuation
33.
If the hedge ratio for a stock call is
0.30, the hedge ratio for a put with the same
expiration date and exercise price as
the call would be ________.
A)
0.70
B)
0.30
C)
-0.70
D)
-0.30
E)
-.17
Answer: C Difficulty: Difficult
Rationale: Call hedge ratio = N(d1);
Put hedge ratio = N(d1) - 1; 0.3 - 1.0 =
-0.7.
34.
If the hedge ratio for a
stock call is 0.50, the hedge ratio for a put with
the same
expiration date and exercise
price as the call would be ________.
A)
0.30
B)
0.50
C)
-0.60
D)
-0.50
E)
-.17
Answer: D Difficulty: Difficult
Rationale: Call hedge ratio = N(d1);
Put hedge ratio = N(d1) - 1; 0.5 - 1.0 =
-0.5.
35.
If the hedge ratio for a
stock call is 0.60, the hedge ratio for a put with
the same
expiration date and exercise
price as the call would be _______.
A)
0.60
B)
0.40
C)
-0.60
D)
-0.40
E)
-.17
Answer: D Difficulty: Difficult
Rationale: Call hedge ratio = N(d1);
Put hedge ratio = N(d1) - 1; 0.6 - 1.0 =
-0.4.
36.
If the hedge ratio for a
stock call is 0.70, the hedge ratio for a put with
the same
expiration date and exercise
price as the call would be _______.
A)
0.70
B)
0.30
C)
-0.70
D)
-0.30
E)
-.17
Answer: D Difficulty: Difficult
Rationale: Call hedge ratio = N(d1);
Put hedge ratio = N(d1) - 1; 0.7 - 1.0 =
-0.3.
537
Chapter
21 Option Valuation
37.
A put option
is currently selling for $$6 with an exercise price
of $$50. If the hedge ratio
for the put
is -0.30 and the stock is currently selling for
$$46, what is the elasticity of the
put?
A)
2.76
B)
2.30
C)
-7.67
D)
-2.76
E)
-2.30
Answer: E Difficulty:
Difficult
Rationale: % stock price change = ($$47
- $$46)/$$46 = 0.021739; % option price change =
$$5.70 - $$6.00)/$$6 = - 0.05; -
0.05/0.021739 = - 2.30.
38.
A put option
on the S&P 500 index will best protect ________
A)
a
portfolio of 100 shares of IBM stock.
B)
a portfolio
of 50 bonds.
C)
a portfolio that corresponds to the S&P
500.
D)
a portfolio of 50 shares of AT&T and 50
shares of Xerox stocks.
E)
a portfolio that
replicates the Dow.
Answer: C Difficulty: Easy
Rationale: The S&P 500 index is more
like a portfolio that corresponds to the S&P 500
and thus is more protective of such a
portfolio than of any of the other
assets.
39.
Higher dividend payout
policies have a __________ impact on the value of
the call and
a __________ impact on the
value of the put.
A)
negative, negative
B)
positive, positive
C)
positive,
negative
D)
negative, positive
E)
zero, zero
Answer: D
Difficulty: Moderate
Rationale: Dividends lower
the expected stock price, and thus lower the
current call
option value and increase
the current put option value.
538
Chapter 21 Option
Valuation
40.
Lower dividend payout
policies have a __________ impact on the value of
the call and
a __________ impact on the
value of the put.
A)
negative, negative
B)
positive, positive
C)
positive,
negative
D)
negative, positive
E)
zero, zero
Answer: C
Difficulty: Moderate
Rationale: Dividends lower
the expected stock price, and thus lower the
current call
option value and increase
the current put option value.
41.
A one dollar decrease in a call
option's exercise price would result in a(n)
__________
in the call option's value
of __________ one dollar.
A)
increase, more than
B)
decrease, more than
C)
decrease,
less than
D)
increase, less than
E)
increase,
exactly
Answer:
D Difficulty: Moderate
Rationale: Option prices
are less than stock prices, thus changes in stock
prices (market
or exercise) are greater
(in absolute terms) than are changes in prices of
options.
42.
Which one of the
following variables influences the value of call
options?
I)
Level of interest rates.
II)
Time to
expiration of the option.
III)
Dividend
yield of underlying stock.
IV)
Stock price
volatility.
A)
I and IV only.
B)
II and III only.
C)
I, II, and IV
only.
D)
I, II, III, and IV.
E)
I, II and III
only.
Answer: D
Difficulty: Moderate
Rationale: All of the above
variables affect call option prices.
539
Chapter 21 Option
Valuation
43.
Which one of the
following variables influences the value of put
options?
I)
Level of interest rates.
II)
Time to
expiration of the option.
III)
Dividend
yield of underlying stock.
IV)
Stock price
volatility.
A)
I and IV only.
B)
II and III only.
C)
I, II, and IV
only.
D)
I, II, III, and IV.
E)
I, II and III
only.
Answer: D
Difficulty: Moderate
Rationale: All of the above
variables affect put option prices.
44.
An American call option buyer on a non-
dividend paying stock will
A)
always exercise the call
as soon as it is in the money.
B)
only exercise
the call when the stock price exceeds the previous
high
C)
never exercise the call early.
D)
buy an offsetting put whenever the
stock price drops below the strike price.
E)
none of the above.
Answer: C Difficulty:
Moderate
Rationale: An American call option
buyer will not exercise early if the stock does
not
pay dividends; exercising forfeits
the time value. Rather, the option buyer will
sell the
option to collect both the
intrinsic value and the time value.
45.
Relative to European puts, otherwise
identical American put options
A)
are less
valuable.
B)
are more valuable.
C)
are equal in
value.
D)
will always be exercised earlier.
E)
none of the above.
Answer: B Difficulty:
Moderate
Rationale: It is valuable to exercise a
put option early if the stock drops below a
threshold price; thus American puts
should sell for more than European
puts.
540
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